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Ruling
Subject: Interest deduction
Question 1
Is the interest expense incurred on the mortgage deductible in its entirety for the period the funds were deposited into an interest bearing account?
Answer
No.
Question 2
Is the interest expense deductible to the extent of the total assessable interest income derived from the high interest bearing account?
Answer
No.
Question 3
Is the interest expense deductible to the extent of the assessable interest income derived from the portion of the funds in the high interest bearing account that was borrowed?
Answer
Yes.
This ruling applies for the following period
Year ended 30 June 2010
Year ended 30 June 2011
Year ending 30 June 2012
The scheme commenced on
1 July 2009
Relevant facts
You had a home loan for your private residence.
You sold your private residence and placed the proceeds into a high interest bearing account.
The funds invested in the interest bearing account exceeded the balance of the mortgage.
You intended to use the funds to purchase, develop and sell a property for profit.
Given the property market was stagnant during this time, you never used the funds for this purpose.
More than 18 months after the funds were deposited into the interest bearing account, you used the funds to purchase a new principal place of residence.
The interest expense exceeded the interest income.
Relevant legislative provisions
Income Tax Assessment Act 1997 Section 8-1
Reasons for decision
Section 8-1 of the Income Tax Assessment Act 1997 allows a deduction for all losses and outgoings to the extent to which they are incurred in gaining or producing assessable income except where the outgoings are of a capital, private or domestic nature, or relate to the earning of exempt income.
Whether interest has been incurred in the course of producing assessable income generally depends on the use to which the borrowed funds have been put. The 'use' test, established in FC of T v. Munro (1926) 38 CLR 153, is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criterion.
In Fletcher & Ors v. FC of T (1991) 173 CLR 1; 91 ATC 4950; (1991) 22 ATR 613 (Fletcher) the Full High Court took the view that if, on consideration of all factors, the whole of the interest could be characterised as genuinely and not colourably incurred in gaining or producing assessable income, the interest would be fully deductible. If only part of the outgoing could be so characterised, apportionment between the pursuit of assessable income and of other objectives was necessary. The court found in that case that it was fair and reasonable to limit the interest deduction to the amount of income actually received.
In your case you had a mortgage over your private residence, which you have since sold. You deposited the funds from the sale of your private residence into a high interest bearing account. You did this with the intention to use the funds to purchase, develop and to sell a property for profit. Given the stagnant property market during this time, the funds were never put to their intended use. You used the funds in the interest bearing account to purchase a new principal place of residence.
Your intention to use the funds at a later date to purchase, develop and then sell a property for a profit does not establish a nexus to the production of assessable income. The interest you incurred in order to have the funds available so that in the future you could purchase a suitable property is incurred at a point too soon to be incurred in the production of any future assessable income from the proposed property development venture.
However, the interest derived from the account is assessable income and is partly attributable to the funds borrowed. A deduction for some amount of interest is therefore appropriate.
It is considered that your circumstances are consistent with those examined in Fletcher. A deduction for interest incurred on the borrowed funds subsequently placed in an interest bearing account is allowed to the extent of the interest received from the borrowed funds.
Please note that as the amount deposited into the account was more than the borrowed amount (that is, the sale proceeds exceeded the mortgage balance owing), then not all of the interest income has been generated from the borrowed funds. You would have to calculate how much of the interest income relates to the borrowed funds. For example, if the mortgage balance owing was only 80% of the amount deposited into the account then only 80% of the interest income was generated by borrowed funds and therefore, the deduction for the interest expense would be limited to 80% of the interest income.